Investors Should Concentrate on Investment Concentration

by Trevor Reid

A lot of smart investors, including the Oracle of Omaha himself, Warren Buffett, suggest that novice investors avoid day trading and, instead, invest in low-cost index funds. Those who dabble in Meme stocks or cryptocurrencies may end up wishing that they had heeded his advice, but what about investors who do follow it now? They have benefitted from a decade in which the S&P 500 has earned nearly 15% per year. But how did it get there? It was not through the old proverb that many hands make light work. A relatively small group of stocks have powered the market forward. You may have heard of the FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google.) Over the past ten years, these companies have led much of the innovation we enjoy in our everyday lives. They have also earned huge profits for those endeavors, and the value of their stock reflects those profits. At the end of 2000, Microsoft was the largest of those stocks and had a market capitalization of $230 billion. Today, that number stands ten times that amount at $2.3 trillion but is now smaller than Apple.  

So, what does all this growth for this handful of stocks mean for index investors? It means their 500 holdings may not be as diversified as they think. For every $100 they invest into the S&P 500, over $22 goes into these five technology stocks. We know that Amazon, Facebook, and Google are not technically considered “technology” stocks. Still, it is simple to see that their earnings power is clearly linked to technology. 

The concentration of the S&P 500’s largest five stocks is even greater than its apex during the dot-com bubble of 1999. This fact is mentioned to provide some perspective to the current situation. Not to imply that these stocks are predicted to suffer the same painful fate as what came from the bursting of the tech bubble in the late 1990s. The five top stocks may be richly priced, but they also have strong earnings and balance sheets. Part of their emergence as stock market warriors has been corporate performance, but some can be attributed to the growth of index funds over time. Forty years ago, indexing was in its earliest stages. As of 12/31/2020, over $5.4 trillion dollars is indexed just to the S&P 500, according to S&P Global. This growth of passive management combined with low fees and the set it and forget it mentality means that the market’s predictive ability around a particular company’s future success has been muted. There is less money in the hands of managers looking into their crystal balls and buying and selling stocks based on the company’s performance which has historically moved stock prices relative to one another. The S&P 500 is weighted by market capitalization. If a stock was a winner before, it would remain a winner in the eyes of the index fund. 

No one can predict if and when these mega-companies will run into trouble or what those troubles may be – operating issues, regulatory restraints, etc. Still, it would be wise for investors to understand that some index funds are not as diversified as they were a decade ago or as safe as some investors might assume.  

Investors can receive worse advice than following Mr. Buffett’s suggestion regarding proper diversification. It is a proven premise. However, digging deeper and confirming a portfolio is as diversified as expected should be a close corollary to the rule. 

Securities offered through M Holdings Securities, Inc., a Registered Broker/Dealer, Member FINRA/SIPC. Investment Advisory Services offered through Cornerstone Advisors Asset Management, LLC, which is independently owned and operated.

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